When Inflation Helps
Est. Reading Time: 20-25 Minutes
Following a handful of talks and presentations I gave this year on inflation, which influenced the Inflation blog post, an expected follow-on question has been “but what do I do about it?”
The knowledge of something hazardous is necessary, but not sufficient, to protect yourself from it. Most of the effort is in the action and unfortunately it has been a long time since we have had to act when it comes to inflation.
There are commonly touted remedies such as commodities or real estate. But, telling me to focus on a broad industry class doesn’t really answer my question. For instance, if commodities, am I to purchase the commodity itself or the producer? Within real estate, what property type and what location?
Goldilocks and Three Bearish Suggestions
Since this question gets asked across a broad range of financial literacy and/or interest levels, I’ll present three layers of opinion on how to respond to inflation. Each layer will go a bit further into the data direction, so if at any point the porridge seems “just right” then no further reading is necessary.
The First Layer, Investing in Yourself
Admittedly this first layer is not a novel idea and if you run a quick search for what to do during inflation some version of this will come up. But, despite its commonality it is not wrong and it’s worth explaining in a more technical fashion rather than letting it wobble into the self-help corners of the internet.
What this is actually saying is that you (likely) have two existing or potential sources of income. The first is your day-to-day job and the second is whatever savings and investments you have accumulated that might produce additional cash flow if allocated correctly. Between those two, it is more efficient to focus on the day job.
Here is the reason why.
Let’s say you make $100K per year (ignore taxes). The typical full-time job equals 2,080 hours a year bringing your income to a rate of just over $48 per hour.
Let’s say you also have $100K saved (1x your salary) and you are wanting to invest it so that it can begin producing additional income for yourself. You choose to passively invest into an index fund, and you match the market return of 10% (choosing a round number but that’s close to the historical average).
Now, if we were to pretend that the investment account was another you working 2,080 hours a year that version of yourself made $4.80 / hr. ($10K / 2,080 hours over the year). Additionally, you generated the $10K passively and it didn’t require any time or work on your part.
At this point many people look at these two streams of income and begin devising ways to increase that 10% rate of return. Unfortunately, this leads most to take on more risk (options, crypto, etc.) but for arguments sake let’s say you have a route to increase these returns another 10% without venturing into the riskier areas of the investment world. This would bring your returns from 10% to 20%, which would put you in the top 1% of the professionals. Instead of $10K at the end of the year you have $20K for some additional effort on your part.
But we must weigh this against your alternatives. Since you make $48 per hour in your day job, those additional returns on your investments need to be achievable in less than four additional hours of work a week if it is to be at least an equally productive use of your time ($10,000 / $48 = 208 hours annually). Reduced to the daily level that’s about 45 minutes per working day.
So, before even getting to the inflation part, is it reasonable to assume that you can add another 10% to reach market toping performance with just an additional 45 minutes per day? Or is it a more prudent use of that time to do more of what you are already doing well?
These numbers are chosen specifically at a return level that most professionals can’t even hit to show that even if you can beat them, it is hard to justify allocating time away from one’s specialty. And since this is done as a multiple of your salary, it’ll be the same if you make $1M and have $1M saved to invest.
Now let’s add inflation.
Like it or not, you, me, everyone is an economic input for some enterprise somewhere and somehow. This is not necessarily a bad thing. What that means is that in an inflationary environment the cost of labor, just as the cost of milk, bread, energy, etc. goes up. While the effects are not uniformly distributed, labor is nevertheless a cost of doing business and is subject to the same inflationary forces as everything else.
At the time of this writing, inflation is running at about 8% per the Bureau of Labor Statistics. Assuming that your particular job is right in line with that, might there be a better way to spend those 45 minutes per day rather than trying to boost your investment returns?
Instead, let’s assume you spend the equivalent of 45 minutes per day acquiring additional skills or certifications. Ones that would allow you to negotiate a higher salary. And let’s assume that these skills or certifications would amount to a raise of 10% (this has been set equal to the gains from the investment path).
You spend the entire year acquiring these valuable skills or certifications, requiring the same 208 hours as the investment path above, and negotiate the raise that is in-line with the additional value you now bring to your job. But, due to inflation, you actually get a 16% raise to help adjust for that as well.
Note that your employer is still saving about 2% (10% more valuable employee + 8% inflation = 18%). But, since I don’t know of many employers that would voluntarily raise their labor costs, at the individual level some catalyst for having the conversation about a raise is typically needed. Or one could switch companies along with the newly acquired skills or certifications.
Now to compare the two outcomes.
For the additional time focusing on investments, at 208 hours over the course of the year, you generated an extra $10K or $48 per hour (remember we pegged it to your current hourly income).
For focusing on job skills, at 208 hours over the course of the year, you generated an extra $16K or $76.92 per hour. Additionally, you do not have to put those 208 hours in again next year as you’ve moved your salary to $55.76 per hour across the 2,080 hours you’ll work next year.
Until you are dealing with an investment sum that is multiples above your annual salary, or you have truly maxed out your chosen career trajectory, focusing on your core job will always have a higher return on time invested. During an inflationary environment this is exacerbated.
One could obviously play with the numbers to try and justify the contrary. So, since the end goal here would be to have the investments return MORE than your salary potential, to drive home how much savings you’d need to have the table below shows the number of years of salary invested it would take at various returns to cover your salary.
Those cells that are both colored green and have green text, are those that have you replacing your salary in a year or less of returns for returns up to 20%. So, in our example of being able to consistently put up 20% returns, you’d still need at least 5x your annual salary invested before you can even start to entertain whether your time is better spent investing.
In reality, this is even being too rosy as you would only actually consider the return above the passive approach. Meaning, since I can make 10% passively in the example above, only the additional 10% that requires me to work should be measured against my day job. In a true apples to apples comparison you wouldn’t quit your job until you had 10x with the assumptions above.
This does not mean don’t invest. Rather, this is what is meant by investing in yourself during inflationary times. Skills, more experience, even willingness to simply work more hours, will all provide a greater throughput than almost any other avenue and will subsequently make the rising prices you are having to pay in your daily life sting a bit less.
The Second Layer – A Basket Approach
Moving away from the individual, probably the most common approach in discussing inflation is through an industry lens. That is, which broad based sector or specific commodity industry should I pick to save myself from this economic erosion.
***A Note - For all historical return data, the Ken French Data Library and FRED were used going back to 1955***
Looking back on the last seventy years;
In the case of rising inflation, coupled with rising GDP: technology, small cap value, energy and manufacturing all beat the average return of the S&P 500. Surprisingly gold returned almost precisely the same rate as the S&P 500 but with much more volatility.
In the case of rising inflation, coupled with shrinking GDP: energy, small cap value, healthcare, utilities, consumer non-durables, telecom, technology, and gold all produced returns higher than the S&P 500. However, only utilities and energy did so with less volatility.
The overall outcomes have been rounded to the nearest whole and half percentages to make it easier to read in the table.
We’ll get the disclaimer out of the way and say that the future does not always resemble the past. But we are looking to be approximately right rather than precisely wrong, and this gives us a good starting point to discuss what sectors might be the best to deal with inflation.
First, a thought on gold. This is supposed to be the sure-fire way to break the shackles of the fiat currency system and rid yourself of their wealth eroding characteristics. True, currencies are and will continue to lose their value over time but a negative structural characteristic of one thing does not instantly validate the desirability of another.
Looking at the historical run gold has had; it does not seem like such an easy way to skirt inflation as the volatility has always been greater than the overall market during times of inflation. Additionally, gold is a poor option for value creation as its only inherent quality is that it is not subject to a central authority creating more (we are going to ignore jewelry and the few industrial uses). While this feature is useful, an ounce of gold will also never grow into a second or third ounce as a company might.
The one way I will endorse the use of gold is as a zero carry (no cost, other than opportunity) insurance policy. Meaning, if you are worried about inflation AND maybe the collapse of your local economy or rule of law, gold can be a very different prospect. Having friends and family that can recount stories of savings accounts going to zero in short order from currency debasement, I can agree there is value in this regard. But beyond that, it is of little use, and I have yet to find data to support the contrary against other readily available options.
If one wanted to take the most passive approach, we could stop here and simply invest into a basket of those sectors that have beat the market during past bouts of inflation. But we want to get to an estimate as to why they might do this.
As a qualitative way to simplify, I’ll categorize the above industries into three features that help them to skirt the effects of inflation. We’ll call these critical, costly and compounding and a particular company within any industry may contain one, two or all three of these characteristics.
Costly – the capital required to get an initial operation off the ground is very high compared to the cash flows generated in the early years of operation. This initial large outlay creates a barrier to new entrants that gets larger and larger as inflation drives up the cost to start.
Compounding – the growth potential of the company is sufficiently high, or the business cycle is short enough, to allow sufficient turns to grow or raise prices quicker than inflation.
Critical – the nature of the business is such that demand is relatively unaffected by price or a broad reduction in consumer spending. Items such as food, energy and healthcare are no less needed during boom times as they are during busts.
As an example, since it is relevant at the time of this writing, think of the energy industry. It is both critical and costly. Having both of these characteristics, it makes sense that it has beat the market return during inflationary environments and has done so with smaller drawdowns.
On critical, oil and gas touches every other sector of the economy and our everyday lives. From a macro view, everything that we do as a species can be stated as the repurposing of energy into more productive and valuable uses. Even the arc of civilization can be mapped along the lines of whichever nation or state was utilizing energy more effectively. And while the sources of generation may evolve, energy as a sector will never lose this critical feature since we can’t actually do anything without energy.
On costly, this is a bit more nuanced as the source of energy plays a factor. But we’ll use a barrel of oil to drive the point since this is the bulk of what is meant by the energy sector currently. The cost to initially drill and bring an oil well to production can range from $4M to $7M for onshore US regions. It depends on a lot of factors, but that initial cost is only half the story. To return an already drilled but declining well to better production, it can be refracked and production can be increased again for less than 75% of the cost of drilling a new well.
So, from a barrier to entry standpoint, think of an incumbent company with a portfolio of wells that can all be revisited for less than half the cost of someone trying to enter the market and building the same portfolio from scratch. And we are not even considering the regulatory hurdles.
There are of course pitfalls around the fact that they are all producing essentially the same product (as far as the consumer is concerned), and operational efficiency gains make it a tighter and tighter margin game. But the critical and costly features vastly outweigh these grievances once inflation causes headwinds and this is reflected in the historical performance.
Another example of multiple characteristics would be certain technology companies. A few might land in all three. Think of Google and their suite of products that we use every day. At this juncture I don’t know that anyone can argue that they are not crucial. Between just search and maps alone many people would be unable to find information or where they are going if you took them away. On compounding it is clear to see how they can rapidly drive additional engagement from their dominant search platform.
But the final characteristic, the costly one, is a bit murkier and I believe this is lost many times when investors (specifically value investors) talk about technology companies. When you look at the Gross Operating Profit line on Google’s financials, they have high and relatively steady gross margins. Lately in the mid 50% range but historically in the mid 60%. When we talk about technology companies, we assume they are insulated because they are NOT costly. A bunch of servers and wiring that make up the infrastructure doesn’t cost much relative to what you can earn with them. But this would be missing the ecosystem they operate within.
Why can Google, Twitter, Facebook, etc. grow so quickly? It’s because the “rails” they exist in and use to deliver content is already built and paid for. They do not have to put the phone in your hand, build the communication lines, worry about the network they will utilize to expand their user base, it is all preexisting. Meaning they don’t have to spend for that. To go back to the oil well example above, imagine if there always existed a number of “freebie” wells that you could bring back to production without first having to conduct the initial drilling. You have effectively put yourself in the same advantaged position as the company that had already paid for all of that during times of lower costs.
This is moving towards the realm of subjective as you could try and measure this benefit, but good chance your numbers would be very wrong. Better to just consider the concept and understand the massive leg up this provides certain technology companies.
This does however make competition easier. Which might help to explain the high volatility and the known failure rate within the sector. But, since we are talking about sectors in general, what could be a headwind at the individual level is an inherent strength at the macro. Much as individual restaurants are risky, but restaurants as a concept are robust and unlikely to ever go away as an industry, technology’s ease of deployment creates a similar effect.
This approach of sector selection is meant to keep one from having to dive into an individual company’s financials and rather focus on structural characteristics. Hopefully the examples properly highlight some of these but to button it all up these three features of costly, compounding and critical are all (whether individually or in conjunction) helping to alleviate the same phenomenon that inflation brings about. The Red Queen Effect.
From Charles Lutwidge Dodgson’s (better known by his pseudonym of Lewis Carroll) Through the Looking Glass, the main character Alice encounters this idea while trying to keep up with the Red Queen.
"Well, in our country," said Alice, still panting a little, "you'd generally get to somewhere else—if you run very fast for a long time, as we've been doing."
"A slow sort of country!" said the Queen. "Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!"
Companies who are ill-equipped to shoulder or fight inflation are in a similar situation to Alice. Should they have high or reoccurring capital expenditure needs, lack any pricing power, or be in a business that is not crucial they will be running as fast as they can to stay in the same place while hoping to outlast the storm.
Aside from the three characteristics, which are my attempt at providing a simple categorical framework, the Red Queen Effect is the absolute and applies to many areas of life.
Before making any decision on investing or capital allocation during times of inflation, you should ask yourself if you are about to enter a race with the Red Queen.
The Third Layer – Technical Analysis
While the first two suggestions required no knowledge of accounting or finance, this is the one that folds that in. Here I assume you want to comb through the merits of a specific company or investment to gauge its suitability.
I’ll begin with where the last section left off, the Red Queen Effect. The previous section was essentially answering the question of “which pond do I want to fish in” knowing that companies are going to have to run faster and faster to outpace the effects of inflation.
As shown above, there are some categorical ways to reduce the complexity of that question and arrive at something like “I will pool my investments into energy, small cap value and healthcare and not worry about the rest.”
But can we translate these features that help to stave off inflation into an accounting metric to take us from the sector level down to the individual company level?
Although the world of financial metrics does not need another entrant to muddy things further, I am going to do just that. However, there is a catch. You cannot easily screen for this as with metrics like Price to Earnings (P/E) or Price to Book Value (P/BV). Further, I cannot find any white papers exploring its usefulness nor can I find a clean enough data set that would allow a robust back test. This opinion is from a first-principles perspective.
First-principles thinking, attributed originally to Aristotle, is the best way to take complicated problems and reverse engineer them down to the smallest collection of variables that drive the bulk of the outcome. A company example might be Amazon and their relentless focus on customer satisfaction. As a retailer, first principles would dictate that success requires one thing above all else, happy customers. Everything else is purely in support of that outcome because if you remove that you’re going to be running in place anyhow.
Following suit, if we accept that we are going to be racing the Red Queen, what is required for such a race? It is the ability to continually increase your running speed and more precisely increase it exponentially. How can a company do this? It can either start the race sooner (already spent the capex), or it can accelerate faster than the Red Queen (inflation). Between those two, let’s focus on the acceleration because should that be sufficiently high, we can outpace the hurdle of capex or if we are lucky the business model needs very little initial capex anyhow.
So, to recap, from a first principles point of view;
If we want to survive inflation > We need to outpace our rising costs
If we want to outpace costs > Money IN needs to outpace money OUT and in an accelerating fashion
For money IN to outpace money OUT > The business model needs to turn (i.e. we need transactions)
That final point is our first principle, the business model needs to turn, and it needs to do so fast enough (and/or with enough acceleration potential) to move faster than the world around it.
And for those considering it, sitting still to wait things out is not really an option since all businesses have some base level carry cost.
To be fair, we have also just stated a requirement for growth in ANY environment, it is just more acute during inflation.
A Simple Example – Fast Real Estate vs. Slow Real Estate
To use a real-world example, think of one of the most recommended ways to fight off the effects of inflation, buying real estate. However, this is a diverse sector, and not all real estate is created equal. Let’s consider two different real estate investments with inflation running at 5% per year and each property getting sold in year ten at the same cap rate as it was purchased.
Investment 1 – Industrial property with a 10-year lease to Amazon, 3% rental increases per year
Investment 2 – An apartment building operating on yearly lease agreements
Cap Rate – 5.0% (Purchase and Sale)
It is assumed that the rent on your multifamily asset can only be increased at the rate of inflation. Over the course of ten years the difference that 2% makes (5% vs. 3% increase) becomes apparent. The rent on your multifamily asset is roughly 19% higher than your industrial property and the value (at the same cap rate) is 34% higher.
Although you are getting a locked in 3.0% increase on your industrial property from a credit rated tenant, because your multifamily asset gets marketed to market (repriced) every year those turns start to allow it to drastically outpace the other asset.
This is what is meant by getting turns in the business model. An apartment building’s product is units. The more often you can take a unit and put it back out to market to transact (ink a lease) the better it performs in an inflationary environment.
To highlight this point further, might there a way we can beat the performance of the multifamily asset above?
If rapid turns are the aim, then a hotel has the highest rate of turnover of any other asset within real estate. Its product is effectively repriced every morning. Let’s rerun the numbers putting the same multifamily asset up against a hotel.
Investment 1 – An apartment building
Investment 2 – A hotel without a branded flag like Hilton or Marriott (i.e. freedom in pricing for owner)
Cap Rate – 5.0% (Purchase and Sale)
As before it is assumed rates can only be increased in lock step with inflation and these rates for the multifamily property and hotel were increased annually and monthly respectively. Now by year ten, even though they have grown their pricing at the same rate, the hotel averages a slightly greater income stream thanks to shorter durations between price increases and the value is roughly 6.0% higher.
But, let’s set the rate differential to something similar to the first example in which the multifamily asset was up against the industrial property. Let’s say that since you have more latitude in creating customer demand with a hotel (pricing power) you can increase your prices at the rate of inflation plus 2.0% for an annual rate increase of 7.0%.
The results below show the same approach as before but now the hotel is repricing monthly with an annual rate of increase of 7.0% while the multifamily is repricing annually at a rate of 5.0%.
Cash flow for the hotel in Year Ten is now roughly 22% higher and the overall value (using equivalent cap rates) is 40% above the multifamily asset.
So, assuming all else is equal, due to this pricing advantage, I am buying the hotel. Also, this effect increases as the rate of inflation or pricing increases. If we rerun that last scenario but with inflation at 8% and hotel rates increasing at 10%, the Year Ten difference is 57% higher cash flow with a 2x higher value for the hotel.
In short, turns matter.
Bringing it into the Accounting Realm
With this advantage of business turns established both from a first principles and simple mathematical perspective, we now need to translate it into the financials of a business so that we might identify, evaluate and potentially invest in businesses that have this characteristic.
This is highlighted in GAAP as the Asset Turnover Ratio.
This is not a very widely used metric in the investing world. It is not available on many screeners and not exactly high priority for anyone writing white papers on the financial markets.
So, since we arrived here via a priori thinking let’s take a quick gut check on the hypothesis to ensure we should keep digging.
Those sectors that had the highest asset turnover in 2022 (a time of inflation) include Retail, Energy, Technology, Capital Goods, Basic Materials and Consumer Non-cyclicals. (Source: CSI Market)
We will remove Capital Goods from the analysis since it spans multiple industries to create a top-5 list from which to build a portfolio. As a note, Capital Goods when aggregated actually bettered the performance listed below, but we are keeping the spot check as simple as possible.
S&P 500 (red line) – (16.24%) | Retail (orange line) – (27.72%) | Energy (purple line) – 70.10%
Tech. (blue line) – (23.60%) | Basic Materials (yellow line) – (8.72%) | Consumer Non-Dur. (green line) – (3.86%)
